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Canadian stock analyst Kun Huang has been locked in a Luoyang, China, jail for more than a year, charged with defaming a Canadian company whose shares trade on the New York and Toronto exchanges. In 2011, a report circulated by Huang's hedge-fund employer alleged that ore samples from a mine run by
Silvercorp Metals
tested low for silver content. Unluckily for Huang, Silvercorp's mine is a prominent enterprise in Luoyang, the city in the central province of Henan where prosecutors have charged that he not only defamed the company but used an illegal camera to shoot video of its operations. After a one-day trial on Sept. 10, the analyst, 36, now waits to hear whether a judge will find him guilty and sentence him to three more years in prison. A Canadian consul described the Luoyang jail as "atrocious." Few trials in China end in acquittal.

Researcher Kun Huang is in a Chinese jail awaiting a trial verdict.
Courtesy of Jon Carnes

The researcher is one of hundreds that Chinese media say have been rounded up since May 2012 for helping foreign investors check out U.S.-listed Chinese companies, or for conducting the due diligence required of multinational corporations by their home countries' antibribery laws. Most of those arrested are Chinese nationals, but public attention tends to focus on the foreigners. Chinese television recently broadcast the handcuffed image of well-known fraud investigator Peter Humphrey, a Brit accused with his American wife of accessing state records in the course of background checks performed by their Shanghai-based firm, ChinaWhys, on dozens of Chinese businesses -- including Silvercorp (ticker: SVM).

The researchers' arrests may be a response to the plunging popularity of Chinese shares that trade on U.S. exchanges. Investigators like Huang and Humphrey helped expose unflattering evidence on companies listed here via the back-door maneuver known as a "reverse takeover" -- inspiring a wave of short-selling, delistings, and fraud charges by U.S. regulators (see "Beware This Chinese Export," Aug. 28, 2010).

China stocks generally haven't done well in the past couple of years, and the flow of Chinese initial public offerings in the U.S. has virtually stopped -- just one company came public here in 2013. Chinese executives were understandably dismayed when American investors turned a cold shoulder, yet Beijing also seems to have taken umbrage. An editorial last year by the state-run news agency Xinhua growled that critiques of Chinese firms by U.S. short sellers were malicious acts seeking to "poison reputations of Chinese start-ups for profit" and fueling foreign prejudices against Chinese business.

With the imminent verdict on Huang, the Silvercorp saga has gone the furthest of China's research crackdowns. It is also the best documented, due to a small mountain of written and audio-visual records surreptitiously collected by Huang and his colleagues over the course of their pursuit by Luoyang cops. Huang's hedge-fund boss Jon Carnes shared these recordings with Barron's, as well as with regulators and law-enforcement officials in Vancouver, where Carnes' investment firm and Silvercorp are based. Carnes says Canadian authorities have opened a bribery probe based on his allegations that Silvercorp directed and paid for Luoyang's prosecution of Silvercorp's critics. Among the documents Carnes shared are some that he says show police expenses paid by the Silvercorp mine, one of the biggest employers and taxpayers in the city. The company and the local police have denied any corrupt relationship.

At the least, China's clampdown on business research means that investors will have to place their China bets with less information. The type of research Huang was conducting is akin to that used in the West, part of the "tire-kicking" that responsible stockpickers do before buying or selling short a stock. "I cannot change the way we do investment research in China," says Carnes. "We have to perform on-the-ground research if we want to find out the truth. Our research activities have broken no laws in China or abroad."

"I deeply believe [that] Huang is innocent," said his colleague Haizhang "Michael" Wei in an affidavit he sent to the Luoyang court, after escaping from China to London. Wei took photos and videos that he says show Silvercorp payment receipts piled on the desk of his police interrogator. Silvercorp's "payoffs" made Luoyang police into the company's "tool," said Wei in the August affidavit. Although Silvercorp wouldn't talk to Barron's, it has said the receipts must have been forged by the hedge-fund group. Chinese prosecutors told Huang that they weren't persuaded by his allegations of corruption.

Wei struck an optimistic tone in his affidavit: "Paper can't cover up fire, and the truth eventually will surface."

Before escaping, Wei avoided incarceration by feigning cooperation with Luoyang policemen like Yi Feng, the lead investigator on the case. In one of several conversations with the policeman that Wei recorded, Yi Feng said that the unrepentant Huang would be punished for defaming the police and Silvercorp -- even if the police had to make up charges. "If you're under the foreign economic system or within the context of financial markets," the policeman told Wei in the recording, "freedom of speech is probably OK. But within China, this is inappropriate. They actually broke some laws of our country."

"Huang's good days are numbered," he said. Barron's verified the contents of the recording with two Mandarin speakers.

Yi Feng told Barron's last week that neither he nor his police colleagues were authorized to speak to foreign reporters. He suggested that the U.S. Consulate could submit our questions to China's Ministry of Foreign Affairs—a ministry that Barron's had already queried, to no avail. Silvercorp spokesman Lorne Waldman also declined to answer our questions about China's prosecution of his Canadian company's critics, saying the matter was "the subject of ongoing litigation."

Whatever the verdict in Luoyang, Huang and his colleagues seem justified in their skepticism of Silvercorp's mining. Over the past few years, Silvercorp has steadily revised downward the grade quality it claims for its silver resources, to a level that's now just a third of its initial claims. Earlier this month, Silvercorp seemingly validated the hedge fund's findings, when Silvercorp told shareholders that its ore grade had fallen because its contractors had adulterated the Henan mine's output by adding "waste rock" to the ore to increase their transport payments and mining fees. Since the fiscal year that ended in March 2011, Silvercorp's annual earnings have fallen from 40 cents a share to 16 cents a share. Its New York Stock Exchange-listed shares have slid from their 2011 high of $16 to a recent $3.27.

ANALYST HUANG ARRIVED at the Vancouver hedge-fund firm EOS Holdings in 2006, after finishing accounting and finance degrees at the University of British Columbia. EOS director Carnes had been an early investor in the small companies of China, where he gained a reputation for diligent research. When his on-the-ground research convinced him that a U.S.-listed China stock was much less than it seemed, Carnes didn't mind selling it short. Carnes started publishing his short ideas directly on the Internet, but ran his reports under the pseudonym Alfredlittle.com, fearing that EOS researchers in China would suffer retaliation.

In September 2011, an Alfredlittle.com report raised concerns about Silvercorp's business, and described lab tests of samples that the report said had fallen off mining trucks in Luoyang. As Silvercorp's stock dropped by 20%, its chief executive Rui Feng fought back against what he called a "false and fraudulent" short attack. The company put lengthy rebuttals on its Website and said some parts of its financials had been checked by forensic accountants at KPMG. Silvercorp also filed a "John Doe" defamation suit in New York against its anonymous detractors and called upon the Royal Canadian Mounted Police to search for the alleged fraudsters.

Faster answers came from the Economic Crimes Investigation Unit of Luoyang's Public Security Bureau. Wei says he was told later that the cops found a surveillance photo of a local researcher bringing ore samples to the lab for testing, then discovered that he'd stayed at a hotel near the mine. He gave up the names of Huang and Wei, who were working for the hedge fund in the cities of Chengdu and Xi'an, respectively. Luoyang police arrested Wei on Dec. 20, 2011, releasing him only after he promised to cooperate and paid them the equivalent of about $16,000, which a police receipt called a "return of illicitly obtained funds." A week later, police arrested Huang at the Beijing airport. They strip-searched him, confiscated his Canadian passport and laptop computers, then drove him to Luoyang, where Huang has said he was released after paying about $32,000. Carnes has copies of the booking records, whose witness signatures include the name of a Silvercorp executive.

Over the following months, Wei says Luoyang police tried to get the analysts to sign prewritten confessions that said the analysts had fraudulently run their chemical analyses on roadside rocks instead of Silvercorp ore. The Canadian Huang refused to sign what he said were false statements. But Wei, 33, was a Chinese citizen who couldn't hope that a foreign government would come to his aid. Wei led police to believe he would testify against his colleagues, and he signed confessions that -- now that he has escaped to London -- he says were false and coerced. "If I didn't say what they want," Wei tells Barron's, "I will be put in jail."

The unyielding Huang was jailed on July 22, 2012, a few days after a New York Times article aired the suspicions of EOS boss Carnes -- denied by Silvercorp -- that China's police were doing Silvercorp's bidding. In the New York court hosting Silvercorp's defamation case, Carnes argued in an affidavit that a list of EOS phone numbers and addresses mentioned in a Silvercorp discovery request could only have come from the contact list on a laptop that Chinese police had seized from Huang. The lists from Silvercorp and the laptop had the same typos, said Carnes in his affidavit, and one phone number was actually a Carnes family frequent-flier account number. After denying that the information had come from China's cops, Silvercorp withdrew its discovery request. When Judge Carol Edmead dismissed the suit in August 2012, she said that Silvercorp hadn't identified any false statements in the Alfredlittle.com reports, which she ruled were also protected expressions of opinion. Silvercorp didn't appeal her ruling.

In September 2012, the Canadian newspaper Globe and Mail reported Carnes' claims that Silvercorp was funding the Luoyang investigation. Before his incarceration, Huang had given the newspaper copies of what he said were hotel receipts that police officer Yi Feng billed to a Silvercorp mining subsidiary, as Yi Feng had Huang accompany him on several investigative trips. The Globe and Mail said that its checks with hotels and local tax bureaus supported the authenticity of the receipts. Silvercorp told the paper that Carnes must have forged the documents.

Haizhang "Michael" Wei photographed receipts, above, that he says prove a Canadian company funded a police probe of the two.
Courtesy of Jon Carnes

But Carnes has other evidence he says supports his claim that Luoyang police took Silvercorp's money. On May 8, 2012, still free while under investigation, Wei visited Luoyang's police headquarters in an attempt to recover his passport, on the pretext that he needed it to register for the Chartered Financial Analyst exam. He came away empty-handed, but he did make a recording of his police visit. When police officers left him unattended for a few minutes, Wei crept around their desk, which the shaky video recording shows piled with papers. It shows him snapping away with his iPhone at what he says are travel receipts that coincide with the policemen's trips to interrogate the hedge-fund researchers. The payer shown on the documents is Silvercorp's 78%-owned Chinese subsidiary, Henan Found Mining.

In other parts of Wei's covert recording, Yi Feng warns Wei that he'd better give trial testimony or he'd fare even worse than his "stupid" colleague Huang. The policeman can be identified on Wei's video, because Carnes has a photocopy of what he says is the policeman's official ID card.

The recorded cop acknowledges that some of the companies shorted by the hedge fund had probably been flawed. "But now you messed with Silvercorp, and the issue is elevated," he said. "Now they have some central government leaders' support. So you just have to be punished."

"What happens if we can't find anything in the criminal code? Then we make a new interpretation," Yi Feng continued. "I'll even fabricate a charge on you."

Wei was under house arrest and continuing to feign cooperation in April of this year, when he walked into another town's police station and pretended that his passport had been lost. Unaware of events in Luoyang, these police arranged a rush delivery of a passport, which enabled Wei to fly to Cambodia. With Carnes' help, Wei made it to London where he's waiting to see if Canada will let him go to work for Carnes in Vancouver. He says he even phoned Yi Feng, who pleaded and threatened that if Wei didn't return to testify against Huang, he'd never be allowed back.

HUANG'S STORY IS MORE GRIM. In July 2012, police locked him in a 300-square-foot cell with 24 other prisoners. He has lost 40 pounds. According to people familiar with the Luoyang jail, prisoners are forced to work unpaid in a shop, assembling things like Christmas lights whose 110-volt format suggests a North American customer.

Don Davies, the member of parliament who represents the Vancouver region where Huang's father lives, suggests the Canadian government may be dragging its feet. The administration of Prime Minister Stephen Harper, he notes, has fervidly pursued China's investment and trade. When contacted by Barron's, a spokesperson for Canada's Foreign Affairs Ministry, said, "We are in contact with local authorities and are monitoring the situation closely."

Carnes says his fund is short about 130,000 shares of Silvercorp. After making $2.5 million from shorting Silvercorp shares, he has spent most of it defending Huang, Wei, and himself.

On Sept. 10, Huang was tried on charges of criminally defaming Silvercorp and using an illegal spy camera to video the company's mine. Wei didn't return to testify against him. Only Huang's two lawyers and a lawyer from Silvercorp were allowed to attend the proceedings. According to notes that the defense lawyers passed along to Carnes, police officer Yi Feng said that the desk and travel receipts shown in Wei's video were not Yi Feng's. When defense lawyers asked Yi Feng about his recorded comments, they say he had no answer.

Carnes argues that jailing investment researchers is the wrong way to try lifting China's stock valuations. "Corruption just makes investors lose trust," he said, "which is the most important factor influencing investment decisions in foreign equities."

Research for this story was contributed by Saranya Kapur and Vincent Loncto.